Securities Law Updates | New Judicial Opinions

May 12, 2008

CA Appellate Court Rules Against Consolidated, Upholds Desist Order

Consolidated Management Group, LLC, et al. v. Department of Corporations
No. A117513, 2008 WL 1850310, Court of Appeal, First Apellate District, Division One, California, 4/28/2008

CA Appellate Court Rules Against Consolidated, Upholds Desist Order


The Court of Appeal of the 1st District of California affirmed the defendant-respondent California Department of Corporation’s ("DOC) desist and refrain order against petitioners relating to their offer and sale of interests in two partnerships. Petitioner Consolidated Management Group, LLC (“Consolidated”) had formed two general partnerships engaged in the purchase and lease of oil and gas exploration and drilling equipment. In response, the DOC issued the questioned order, which was upheld by the Superior Court of San Francisco County. According to the Court of Appeal, securities offerings must actually qualify for a valid federal securities registration exemption, rather than only being sold pursuant to a putative exemption, in order to enjoy preemption from state regulation under the National Securities Markets Improvement Act of 1996 (NSMIA) and state statute. Here, the Court of Appeal found that substantial evidence established that the venture interests were covered securities subject to registration. Specifically, the partnership agreements presented to potential investors did not confer management powers, and that investors were essentially dependent on the managerial ability of petitioners.

Detailed Summary:

Petitioners in this appeal were Consolidated Management Group, LLC (“Consolidated”), Consolidated Leasing Hugoton Joint Venture # 2 (“Hugoton”), and Consolidated Leasing Anadarko Joint Venture (“Anadarko”).  Consolidated, a Kansas limited liability company with its principal place of business in Hutchinson, Kansas, established a number of Kansas general partnerships, including Hugoton and Anadarko, that purchased oil and gas exploration and drilling equipment and leased the equipment to oil and gas operators. This case arose from the sale of units of joint venture interests in Hugoton and Anadarko, which have their principal places of business in Wichita, Kansas. Among others, the August 5, 2005 private placement memorandum for Hugoton provided for the sale of 116 units at $50,000 per unit; the October 1, 2005 memorandum for Anadarko provided for the sale of 100 units at $62,000 per unit.

Petitioners appealed the judgment of the Superior Court of San Francisco County that denied their petition for a writ of administrative mandamus. This petition sought a reversal of respondent DOC decision rejecting their challenge to the Department’s desist and refrain order enjoining the offers and sales of interest in Hugoton and Anadarko.

Consolidated engaged the services of Guardian Capital Management (“Guardian”) to raise capital in Northern California for Hugoton and Anadarko.  The DOC issued a desist and refrain order in January 2006 against Guardian, Guardian’s president, Kenneth Keegan, and Guardian operatives Faber Johnston and Brandon Taylor, as well as Consolidated, Hugoton, and Anadarko. The order charged that these entities and individuals had engaged in general solicitation of the public for the offer and sale of Hugoton and Anadarko units, that the units were securities subject to qualification under California law, and that the securities had been offered and sold without being qualified in violation of Corporations Code section 25110.

Presented before the Court of Appeal were the following issues: (1) whether federal law preempts the DOC’s authority to issue the desist order; and (2) whether the interests in Hugoton and Anadarko are securities. In affirming the DOC’s decision, the Court of Appeal agreed that substantial evidence supported the DOC’s finding that the interests in question were securities.

Under section 25110, “(i)t is unlawful for any person to offer or sell in this state any security in an issuer transaction ... unless such sale has been qualified ... or unless such security or transaction is exempted….” On the other hand, Section 25102.1, subdivision (d) exempts from section 25110 “[a]ny offer or sale of a security with respect to a transaction that is exempt from registration under the Securities Act of 1933 pursuant to Section 18(b)(4)(D) [15 U.S.C. § 77r(b)(4)(D) ] of that act,” provided that a copy of a completed Form D and a consent to service of process are filed, and a notice filing fee is paid, as was done by Hugoton and Anadarko in this case. Transactions are exempt from registration under the federal statute if they comply with the requirements of Rule 506 of Regulation D (17 C.F.R. § 230.506 (2007)) for limited private placements (15 U.S.C. § 77d(2)), which include a prohibition against any form of general solicitation (17 C.F.R. § 230.502(c) (2007)). Petitioners did not dispute the Department’s finding, upheld by the Superior Court, that interests in Hugoton and Anadarko were offered through general solicitations in contravention of the federal rules for private offerings.

Petitioners however argued that California is preempted by federal law from requiring that the sales of those interests be qualified as provided in section 25110. They based their assertion on the National Securities Markets Improvement Act of 1996 (NSMIA; 15 U.S.C. § 77r), which preempts state laws requiring the registration or qualification of a “covered security” (15 U.S.C. § 77r(a)(1)).

However, the Court of Appeal rejected such argument, stating that the NSMIA unambiguously defines a “covered security” as one that “is exempt from registration,” not one that “is sold pursuant to a putative exemption.” In re Blue Flame Energy Corp (Ohio Ct.App. 2006) 871 N.E.2d 1227, 1243-1244)(”Blue Flame”). Offerings must thus “actually qualify for a valid federal securities registration exemption in order to enjoy NSMIA preemption.” (Brown v. Earthboard Sports USA, Inc. (6th Cir. 2007) 481 F.3d 901, 910-912))(”Brown”).

Thus, in sustaining the holding of both the trial court and the department, the Court of Appeal wrote that a security has to actually be a “covered security” before federal preemption applies.” (Apollo, supra, 158 Cal.App.4th at p. 250, quoting Hamby v. Clearwater Consulting Concepts, LLP (E.D.Ark. 2006) 428 F.Supp.2d 915, 921)(”Hamby”).

Next, petitioners argued that the Department erred in finding that the joint venture interests are securities.  The Court of Appeal again rejected petitioners’ assertion. Under section 25019, an “investment contract” is listed as a “security.” In determining whether the transaction in this case is an investment contract, the Court of Appeal applied the federal test described in SEC v. W.J. Howey Co. (1946) 328 U.S. 293, 298-299)(“Howey”). Under the federal test, an investment contract is “a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.” (Howey, supra, 328 U.S. at pp.298-299).  On the other hand, in determining whether a general partnership interest is a security, the Court of Appeal applied the rule laid down under Williamson v. Tucker (5th Cir.1981) 645 F.2d 404)(“Williamson”).

Hence, under Williamson, “a general partnership or joint venture interest can be designated a security if the investor can establish, for example, that (1) an agreement among the parties leaves so little power in the hands of the partner or venturer that the arrangement in fact distributes power as would a limited partnership; or (2) the partner or venturer is so inexperienced and unknowledgeable in business affairs that he is incapable of intelligently exercising his partnership or venture powers; or (3) the partner or venturer is so dependent on some unique entrepreneurial or managerial ability of the promoter or manager that he cannot replace the manager of the enterprise or otherwise exercise meaningful partnership or venture powers.”

Here, the joint venture agreements showed that Consolidated was the managing venturer, and had authority over the ventures’ day-to-day operation.  But the other venturers had the right to remove Consolidated as the managing venturer by a majority vote. Collective management and control were placed in the hands of all the venturers. Since the agreements granted power in a manner found in a general partnership rather than a limited partnership, the joint venture interests were not securities under the first Williamson factor.

Going over to the second factor, the Court of Appeal saw that it weighed against the petitioners.  Specifically, it found that Keegan himself admitted that Chamber members had no experience in the oil and gas industry.  This evidence gave basis to the factual finding that petitioners solicited investments from people who would, as a practical matter, lacked the knowledge to effectively exercise the managerial powers conferred by the joint venture agreements.

With regard to the third Williamson factor, the Court of Appeal similarly found that it weighed against petitioners. In particular it found that in the private placement memoranda, the ventures purchased specified lists of equipment from Consolidated affiliates at a price determined by Consolidated, and then leased by Consolidated, possibly again to Consolidated affiliates.  Further, in addition to equipment selection and price specification, Consolidated’s pre-purchase activities included drilling that revealed where natural gas was located, and the acquisition of the rights to those locations.

Even though Consolidated might be correct in denying that it had unique expertise in the field of oil and gas in general, the Court of Appeal nevertheless stated it was “reasonable to find that the success of the particular projects marketed here was uniquely dependent on Consolidated efforts, and that investors would be relying on those efforts in making their investments.”

On the basis of the foregoing, substantial evidence demonstrated that the joint venture interests were securities under two of the three Williamson factors. These controlling Williamson factors satisfy the federal test for a security.

The Court of Appeal thus affirmed the questioned judgment of the Superior Court.

View a PDF of the judicial opinion

Companies Mentioned

California Department of Corporations

Consolidated Leasing Anadarko Joint Venture

Consolidated Leasing Hugoton Joint Venture #2

Consolidated Management Group, LLC

Guardian Capital Management

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Companies Mentioned

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Securities and Exchange Commission

Harris Associates, L.P.

Banc of America Securities LLC

Citicorp USA, Inc.

The Public Employees’ Retirement System of Mississippi

Morgan Stanley & Co., Inc.

Jan Charles Finance S.A.

Park East, Inc.

CIBC World Markets Corp.

Citigroup Inc.

Barclays Capital Inc.

Citigroup Global Markets, Inc.

Torchmark Corp.

Beckstead and Watts, LLP

Barclays Bank PLC

KPMG Peat Marwick, LLP

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BNY Capital Markets, Inc.

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Credit Suisse Securities (USA) LLC

Credit Lyonnais Securities (USA) Inc.

The Cleaners & Caulkers Local 1 Pension Fund

Credit Suisse, New York Branch

Ameriprise Financial, Inc. f.k.a. American Express Financial Corp.

Deutsche Bank AG

California Department of Corporations

The Royal Bank of Scotland plc

RiverSource Investments, LLC

Harris Nesbitt Corp.

Consolidated Management Group, LLC

The Bank of Nova Scotia

Asset Management Holding AG

Deutsche Bank

Toronto Dominion Texas, LLC f.k.a. Toronto Dominion Texas, Inc.

Alex Brown, Inc.

Tellabs, Inc.

Deutsche Bank Securities, Inc.

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Lydia Capital, LLC

Suntrust Capital Markets, Inc.

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